Turning South

SN STAFF

The recession that has battered the United States for several months made a sudden arrival in Canada late last year, bringing with it a chill of consumer caution expected to affect the fortunes of Canada's food retailers at least through the balance of the year.

“We are prepared for a challenging 2009,” Galen Weston, executive chairman of Canada's largest grocer, Loblaw Cos., said last month in a conference call. More recently, Loblaw's president and deputy chairman, Allen Leighton, described an economic downturn expected to last 12-18 months — with repercussions that could continue far longer than that.

“Anybody thinking about running their company the same way they did 12 months ago is going to have a problem,” Leighton maintained. “Things are changing big-time.”

As consumers reel in spending, retailers will have to be at the top of their games to compete, observers said. In Canada, that will highlight initiatives such as Metro's conversions to a common banner at former Dominion and A&P stores; Loblaw's work to improve its Superstore and “Great Food” concepts; and Sobeys' ongoing efforts to craft effective small-concept vehicles. And all chains will need to manage their respective discount banners and private-label lines effectively, particularly now with Wal-Mart Stores expanding supercenters across the country.

Mark Carney, the director of Canada's central bank, has been optimistic in the face of worsening economic news, including a decrease in demand for Canadian exports due to slowdowns in the U.S. housing and automotive markets. But in a speech earlier this month, he acknowledged that “severe global headwinds” would make a Canadian recovery take longer than expected.

Unemployment in Canada rose to 7.7% in February — its highest level in five years, according to Statistics Canada. The surge in unemployment reflects both a slowdown in manufacturing in Ontario and the impact of declining oil prices on oil-rich Western Canada. Unlike the U.S., however, Canada did not suffer from the sub-prime mortgage fiasco that triggered massive foreclosures and crippled banks. The housing market in Canada has weakened in the current environment, but its banks remain strong, analysts pointed out.

Inflation Lingers

Statistics Canada last month also revealed that the price of food purchased in stores last year increased by 3.9% during 2008, with a price spike in the fourth quarter led by sharp rises in the cost of food staples such as bread, rice, flour, milk and eggs.

Perry Caicco, an analyst with CIBC World Markets, Toronto, said the decline in the value of the Canadian dollar relative to the U.S. is playing havoc with Canadian retailers' purchasing power.

“We are cycling through a very unfavorable dollar — down 18% or 19% off a year ago — so we are buying goods from the U.S. using a weaker dollar, and the result is pretty rapid inflation at store level. We've had a big run-up in produce.”

The increase in the cost of buying from the U.S. has offset any benefit that retailers might have obtained from declines in commodity prices, he explained.

“If the dollar stays where it is, around late August or early September, then there could be deflation in the back half of the year,” he predicted.

The sudden economic weakness in Canada was met with an abrupt consumer spending slowdown across the country, according to Dave Marcotte, director of retail insights for Management Ventures Inc., Cambridge, Mass.

“The Canadian consumer tends to be far more likely to turn off spending when the economy goes bad, as opposed to the U.S. shopper,” Marcotte told SN. “The Canadian consumer during one week in December went from going 100 miles an hour to zero. That's a very Canadian thing. And that's something retailers are looking at. If you are basing your projections on the first three quarters of last year, and then this hits the fan, it makes projections very difficult.”

That in part is why Loblaw, despite showing progress on several fronts in its ongoing turnaround, struck a cautious posture in its outlook for 2009. Leighton noted that retailers can do little about price inflation (which enhances revenues and increases buying leverage but masks productivity and volume declines and worries consumers) or deflation (which puts margins under pressure) but should act to control disinflation by anticipating a consumer flight to value.

Loblaw is also amassing a war chest in part to improve scale and facilitate consolidation, he said.

In Ontario, Marcotte said he was impressed with the impact that Metro has made by rebannering former A&P and Dominion stores under the Metro name there. The changes, he noted, were relatively minor but brought new life to tired assets.

“For us, it looks like a minor makeover. But for a customer, that might be enough, and the numbers seem to support that,” Marcotte said. “The majority of the Dominion stores were food museums. They'd lost their way. They were gorgeous stores but there were nobody in them. You go in now and you'll see they've got customers.”

Sobeys, which developed its small-format expertise partially as a result of being forced into it in Ontario's crowded population centers, has also impressed Marcotte.

“I've never yet walked into one that wasn't busy as all get-out,” he said. “They seem to have hit that particular market very well, with a size of store you don't see in the States.”

Wal-Mart's Influence

In some ways, the actions that the major supermarket operators have been taking to compete with the influx of Wal-Mart supercenters have prepared them well for a consumer slowdown. Wal-Mart began opening the full-line supercenters in Ontario in late 2006 and has since opened about 56 such stores throughout the country.

“Everybody has had to respond in some way, shape or form to Wal-Mart's pricing,” said Caicco of CIBC. “We've referred to it as the tail that wags the dog — we have companies like Loblaw and Overwaitea and Metro that have much larger sales than Wal-Mart does in food, but when Wal-Mart sets its food pricing, everyone has to adjust to that.”

He noted that the discount format was already much more established in Canada than it was in the U.S. — and that the major supermarket operators each have their own discount banners separate from their traditional formats. This has helped them weather Wal-Mart's incursion.

In fact, he noted that in Western Canada, where Loblaw's Superstore concept has long been a dominant force, the expansion of Wal-Mart's grocery offering has prompted Loblaw to expand its smaller discount banner, called No Frills, in that region.

Caicco said the impact of Wal-Mart's expansion in Canada has been spread out among all operators.

“Where Wal-Mart has opened supercenters, there have been a number of competitive store closures,” he said. “But all of the stores that have been closed have been typically the worst asset in the market, and they probably would have been closed at some point down the road.

“So there's been a bit of throwing in the towel, but it's been very spread out, and it is not focused on any one particular retailer.”

In general, however, Canadian retailers have been better prepared for Wal-Mart's expansion into the grocery sector than their U.S. counterparts, said Marty Weintraub, vice president of the grocery practice at consulting firm Karabus Management, Toronto.

“When you look at the same-store sales released by Metro and Sobeys recently, they are very, very healthy,” he said. “They had a stellar performance, and I think it's all because they were much better prepared for Wal-Mart in Canada than the U.S. chains were.”

He noted that both the traditional formats and the discount banners in Canada have reacted to Wal-Mart by introducing more promotions and getting sharper on pricing.

In addition, he said, Canadian retailers have re-energized their private-label lines — Loblaw has been placing increasing emphasis in its circulars on its No Name value-tier brand, Weintraub noted — and Metro has revamped and expanded its store brands. At a recent CIBC conference, Metro said it has seen double-digit growth in private-label sales, and that it plans to add some 2,000 items to its premium Irresistible and national-brand equivalent Selection lines by the end of the year.

“The economy is about three to five months behind the U.S. in terms of the economic cycle, but the big chains are getting ready now,” Weintraub said. “That means either they are getting sharp on price, or having the right ads for the right time.”

In general, he said, the big Canadian chains are well positioned. “Canadian players are more sound; they have good balance sheets and lots of cash.”

Battle in the West

The battle is just now shaping up in Western Canada as Wal-Mart expands its supercenter presence there and Loblaw Cos. leads the discount charge against it.

“There are obviously some growth opportunities for discount formats in the west,” one local observer told SN, “but consumers who want price, service and quality will stick with the conventional operators and those who want price will have ample choices, and it's the independents in-between who are likely to struggle.”

Wal-Mart began opening supercenters in Western Canada in late 2007, with 10 in Alberta and two in British Columbia at the end of 2008, and another 12 to 15 expected to be operating in the west by year's end — including the first supercenter locations in Manitoba and Saskatchewan.

Wal-Mart's western expansion comes as Loblaw tries to reposition its operations there by converting its conventional Extra Foods stores to discount-priced No Frills outlets; opening additional No Frills units in urban centers; and re-establishing a price and quality reputation at its Real Canadian Superstores.

Among other operators in Western Canada:

Going into 2009, Loblaw remained the dominant player in Canada's four western provinces, with 203 stores under various banners and a market share estimated at 27%; followed by Safeway, with 217 stores and a 20% share; Overwaitea, which operates 117 stores under multiple banners, with a 14% share; Sobeys, with 158 stores and a 7% share; and Wal-Mart supercenters, with 12 stores and a 5% share.

But Wal-Mart's share will grow as it moves toward opening as many as 200 supercenters in Western Canada within five years, Ryan Balgopal, an analyst with Scotia Capital, Toronto, pointed out.

The conversion by Toronto-based Loblaw of its conventional Extra Foods stores in the west to the discount No Frills format is a good move, since No Frills prices goods below Wal-Mart by 5% to 6%, Caicco of CIBC said. “[However], although No Frills is an excellent introduction to Western Canada, it will take [at least three] years … for the store base to be adequately supported, for customers to figure out the concept and for managers to learn how to operate them efficiently,” he pointed out — “particularly given the rapid pace of Wal-Mart rollouts.”

Loblaw already has a discount chain operating in Western Canada — the Real Canadian Superstore, a 71-store format established in the early 1990s to emphasize Loblaw's home-grown roots against American-owned Safeway — “but those stores lost their discount image years ago,” George Condon, an industry consultant, told SN.

When Loblaw adopted its “One Company” strategy in 2003 and sought to nationalize its business, it lost its competitive edge in the west by tampering with the RCSS core proposition of a stripped-down store offering with stripped-down prices, Caicco noted.

Safeway continues to hold its own in Western Canada because of its large number of locations and the quality of those locations, local observers said.

Although Safeway is converting stores to the lifestyle format, as in the U.S., it has also become more value-oriented of late, advertising “4,000 items specially priced every day,” Condon noted.

However, with more overlap between units of Safeway and future Wal-Mart supercenters, Safeway will face more price competition from Wal-Mart than any of its competitors, Balgopal said.

There's been rampant speculation on both sides of the border that Safeway will ultimately sell its Western Canada operations (including the six stores it operates in Ontario), “but probably not until they're ready to buy another chain in the U.S.,” one Canadian analyst told SN. “Safeway doesn't need the cash right now, so the catalyst for any sale of the Canadian operations will likely be some interest in buying another U.S. asset.”

Overwaitea, based in British Columbia, operates 15 Overwaitea-banner stores, all in British Columbia; 73 Save-On Foods, including 51 in British Columbia and 22 in Alberta; and 11 Price-Smart discount stores in British Columbia.

Sobeys, based in Eastern Canada, operates 100 corporate and franchised stores and 57 IGA stores in Western Canada, all of which are conventional, plus a single Price Chopper discount store — all but two of them operating outside of British Columbia.

Sobeys has been giving the IGA operators it serves the option of converting their stores to the Sobeys banner, though only a handful have made the switch.

While Wal-Mart and RCSS emphasize general merchandise in their mix, Sobeys has boosted its image with the slogan, “We sell food,” to differentiate itself, with positive results, Condon pointed out.

Sobeys moved into British Columbia 18 months ago with the acquisition of Thrifty Foods — a 22-store upscale operator that operates three stores on the mainland and the other 19 on Vancouver Island west of the mainland.

With the influx of capital from Sobeys, Thrifty Foods is expected to become more predominant on the mainland, which could shake things up among conventional players in British Columbia over the next few years.

Metro Conversions

In Ontario, the lion's share of supermarket activity has centered around Metro's conversion of the 159 Dominion, Ultra, The Barn and A&P stores it acquired from A&P to the Metro banner.

The 15-month process, which began last fall, is about half completed.

Caicco of CIBC noted that the conversions “have been pretty modest.”

“They certainly haven't to any material extent lowered their prices,” he said. “They are trying to make sure their margins don't get crushed, by shifting purchase habits into profitable categories. That has been their strategy, and it's worked. The question I have asked in print is, will this hold up in a recession? They have only just done this, so will people be as loyal as this recession continues to dig in?”

He said he believes customers could “sour” on the conversions over time, although he noted that the chain has strong locations in the urban areas of Eastern Canada.

At the company's discount Food Basics banner, Metro has added some SKUs and moved toward more hi-low pricing and slightly away from EDLP, Caicco said, another move that could prove troublesome in an economic downturn, he added. Metro operates 117 units of that banner in Canada.

At the recent CIBC conference, Metro executives were upbeat on the effort, however.

“Metro will be the largest banner in Ontario, with 159 stores,” said Richard Dufresne, Metro's senior vice president and chief financial officer, at the conference. “We think a single-banner approach will be the best way to get things done.”
Reporting by Elliot Zwiebach, Jon Springer and Mark Hamstra